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UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

(Mark One)

For the fiscal year ended December 31, 2003

OR

For the transition period from ____________ to ____________

Commission File Number: 000-49802

Netflix, Inc.

(Exact name of Registrant as specified in its charter)

970 University Avenue

Los Gatos, California 95032

(Address and zip code of principal executive offices)

(408) 317-3700

(Registrant’s telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act:

None

Securities registered pursuant to Section 12(g) of the Act:

Common stock, $0.001 par value

(Title of Class)

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ No ¨

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ¨

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes þ No ¨

As of June 30, 2003, the aggregate market value of voting stock held by non-affiliates of the registrant, based upon the closing sales price for the registrant’s common stock, as reported in the NASDAQ National Market System, was $255,835,855. Shares of common stock held by each officer and director and by each person who owns five percent or more of the outstanding common stock have been excluded in that such persons may be deemed to be affiliates. This determination of affiliate status is not necessarily a conclusive determination for any other purposes.

As of February 12, 2004, there were 51,311,000 shares of the registrant’s common stock, par value $0.001, outstanding (which gives effect to the two-for-one stock split on February 11, 2004).

The following document (or parts thereof) is incorporated by reference into the following parts of this Form 10-K: Proxy Statement for the Annual Meeting of Shareholders—Part III Items 10, 11, 12, 13 and 14.

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NETFLIX, INC.

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PART I

Forward-Looking Statements

This annual report on Form 10-K contains forward-looking statements within the meaning of the federal securities laws. These forward-looking statements include statements regarding: the accuracy of our recommendation service; our plans to open additional shipping centers; impacts from shorter delivery time; strategic initiatives regarding international expansion and downloading; operating expenses; future stock-based compensation; and customer acquisition and retention. These forward-looking statements are subject to risks and uncertainties described under the caption “Factors That May Affect Future Results of Operations” which could cause actual results to materially differ. We take no obligation to revise or publicly release the results of any revision to any forward-looking statements contained in this annual report on Form 10-K, or to explain why actual results differ.

Item 1.     Business

We are the largest online movie rental subscription service in the United States, providing more than 1,487,000 subscribers access to a comprehensive library of more than 18,000 movie, television and other filmed entertainment titles. Our standard subscription plan allows subscribers to have three titles out at the same time with no due dates, late fees or shipping charges for $19.95 per month. Subscribers can view as many titles as they want in a month. In addition to our standard plan, we offer other service plans with different price points that allow subscribers to keep either fewer or more titles at the same time. Subscribers select titles at our Web site aided by our proprietary recommendation service, receive them on DVD by first-class mail and return them to us at their convenience using our prepaid mailers. Once a title has been returned, we mail the next available title in a subscriber’s queue.

Our subscription service has grown rapidly since its launch in September 1999. We believe our growth has been driven primarily by our comprehensive selection of titles, consistently high levels of customer satisfaction, rapid consumer adoption of DVD players and our effective marketing programs. In the San Francisco Bay Area, where we have had generally one-day delivery service since launch, approximately 5.9 percent of all households subscribed to Netflix at the end of 2003.

Our proprietary recommendation service enables us to create a customized store for each subscriber and to generate personalized recommendations which effectively merchandize our comprehensive library of titles. In the fourth quarter of 2003, more than 99 percent of our titles were selected by our subscribers to add to their queue. In comparison, most entertainment service providers promote a narrow selection of box office hits. We believe that our recommendation technology, based on proprietary algorithms and the more than 300 million movie ratings we have collected from our subscribers, enables us to build deep subscriber relationships and maintain a high level of library utilization.

We promote our service to consumers through various marketing programs, including online promotions, television advertising, advertising insertions with most leading DVD player manufacturers and promotions with other third parties. These programs encourage consumers to subscribe to our service and include a free trial period of 14 days. At the end of the trial period, subscribers are automatically enrolled as paying subscribers, unless they cancel their subscription. Approximately 90 percent of trial subscribers become paying subscribers. All paying subscribers are billed monthly in advance.

We stock almost every title available on DVD, excluding mature and adult content. We have established revenue sharing relationships with more than 50 studios and distributors. We also purchase titles directly from studios, distributors and independent producers. These relationships provide us access to titles on financial terms that are attractive to us.

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We ship and receive DVDs throughout the United States. We maintain a nationwide network of shipping centers that allow us to provide fast delivery and return service to our subscribers. As of December 31, 2003, we were capable of providing more than 80 percent of our subscribers with generally one-day service.

We are focused on growing our subscriber base and revenues and utilizing our proprietary technology to minimize operating costs. Our technology is extensively employed to manage and integrate our business, including our Web site interface, order processing, fulfillment operations and customer service. We believe that our technology also allows us to maximize our library utilization and to run our fulfillment operations in a flexible manner with minimal capital requirements.

We are organized in a single operating segment. All our revenues are generated in the United States, and substantially all our revenues are derived from monthly subscription fees.

Industry Overview

Filmed entertainment is distributed broadly through a variety of channels. Out-of-home channels include movie theaters, airlines and hotels. In-home distribution channels include home video rental and retail outlets, cable and satellite television, pay-per-view, video-on-demand, or VOD, and broadcast television. Currently, studios distribute their filmed entertainment content approximately six months after theatrical release to the home video market, seven to nine months after theatrical release to pay-per-view and VOD, one year after theatrical release to satellite and cable and two to three years after theatrical release to basic cable and syndicated networks. However, in what may be an emerging trend, several of the major studios have recently shortened the release window on certain titles, in particular the theatrical to home video window.

Consumer Transition to DVD

The home video segment of the in-home filmed entertainment market has undergone a rapid technology transition away from VHS to DVD. According to Adams Media Research, there were approximately 54 million U.S. television households with a stand-alone set-top DVD player, representing 49 percent of U.S. television households, at the end of 2003. This number does not include other electronic devices, such as computers and video game players, many of which are also capable of playing DVDs. We believe this transition is analogous to the shift in the music industry from audio cassettes to compact discs which resulted in significant additional demand for both new releases and back catalogue inventory. Similarly, we anticipate that DVD will, for all practical purposes, replace the VHS cassette and thereafter, DVD will enjoy a similarly long consumer lifetime. We provide titles to our subscribers on DVD only and have never carried VHS content.

Challenges Faced by Consumers in Selecting In-Home Filmed Entertainment

The proliferation of new releases available for in-home filmed entertainment and the additional demand for back catalogue titles on DVD create two primary challenges for consumers in selecting titles.

First, despite the large number of available titles, consumers lack a deep selection of titles from existing subscription channels and traditional video rental outlets. Subscription channels, such as HBO and Showtime, and pay-per-view services currently offer a narrow selection of titles at specified times due to programming schedule constraints and technological issues relating to channel capacity. Traditional video rental outlets primarily offer new releases and devote limited space to display and stock back catalogue titles.

Second, even when consumers have access to the vast number of titles available, they generally have limited means to effectively sort through the titles. We believe our recommendation service provides our subscribers the tools to select titles that appeal to their individual preferences.

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Competitive Strengths

We believe that our revenue and subscriber growth are a result of the following competitive strengths:

Growth Strategy

Our strategy to provide a premier filmed entertainment subscription service to our large and growing subscriber base includes the following key elements:

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Our Web site—www.netflix.com

We have applied substantial resources to plan, develop and maintain proprietary technology to implement the features of our Web site, such as subscription account signup and management, personalized movie merchandising, inventory optimization and customer support. Our software is written in a variety of languages and runs on industry standard platforms.

Our recommendation service uses proprietary algorithms to compare each subscriber’s title preferences with preferences of other users contained in our database. This technology enables us to provide personalized movie recommendations unique to each subscriber.

We believe our dynamic store software optimizes subscriber satisfaction and management of our library by integrating the predictions from our recommendation service, each subscriber’s current queue and viewing history, inventory levels and other factors to determine which movies to promote to each subscriber. Our proprietary movie search engine indexes our extensive library by title, actor and director.

Our account signup and management tools provide a subscriber interface familiar to online shoppers. We use a real-time postal address validator to help our subscribers enter correct postal addresses and to determine the additional postal address fields required to assure speedy and accurate delivery. We use an online credit card authorization service to help our subscribers avoid typographic errors in their credit card entries. These features help prevent fraud and subscriber disappointment resulting from failures to initiate a trial.

Throughout our Web site, we have extensive measurement and testing capabilities, allowing us to continuously optimize our Web site according to our needs as well as those of our subscribers. We use random control testing extensively.

Our Web site is run on hardware and software co-located at a service provider offering reliable network connections, power, air conditioning and other essential infrastructure. We manage our Web site 24 hours a day, seven days a week. We utilize a variety of proprietary software, freely available and commercially supported tools, integrated in a system designed to rapidly and precisely diagnose and recover from failures. We conduct upgrades and installations of software in a manner designed to minimize disruptions to our subscribers.

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Merchandizing

The key to our merchandizing efforts is the personal recommendations generated by our recommendation service. All subscribers and site visitors are given many opportunities to rate titles. The ratings from our recommendation service determine which available titles are displayed to a subscriber and in which order. For example, our subscribers can find recently released titles more easily by ranking new releases by user preference rather than by new release date, allowing them to quickly find titles they are more likely to enjoy. Ratings also determine which available titles are featured in lead page positions on our Web site to increase customer satisfaction and selection activity. Finally, data from our recommendation service is used to generate lists of similar titles. Subscribers often start from a familiar title and use our “Recommendations” link to find other titles they may enjoy. This has proven to be a powerful method for catalogue browsing.

Recommendations are available to anyone who has rated titles on our Web site, whether or not they are a subscriber. By aggregating the ratings of our subscribers and other visitors, we have built what we believe to be the world’s largest personal movie ratings database, containing more than 300 million ratings.

We also provide our subscribers with decision support information about each title in our library. This information includes:

Marketing

We have multiple marketing channels through which we attract subscribers to our service. Online advertising is our largest paid source of new subscribers. We advertise our service online through paid search listings, permission based e-mails, banner ads, and text on popular Web portals and other Web sites. In addition, we have an affiliate program whereby we make available Web-based banner ads and other advertisements that third parties may retrieve on a self-assisted basis from our Web site and place on their Web sites. Third parties that place our advertisements and generate online subscriber referrals are generally paid a cash bounty for each subscriber referred to us, with no minimum or maximum amounts for which we are liable. We believe that our paid marketing efforts are significantly enhanced by the benefits of word-of-mouth advertising, our subscriber referrals and our active public relations programs. During 2003, online and word-of-mouth advertising accounted for approximately 85 percent of all new trial subscriber acquisitions.

We work with a number of other channels on an opportunistic basis. For example, we have agreements with leading DVD player manufacturers requiring them to place inside certain DVD player boxes a Netflix insert that describes our service and offers a free trial. We also have a relationship with a leading consumer electronics and video retailer, which involves a variety of promotional efforts using point-of-sale materials, stickers on product packaging and other items to promote Netflix in its stores and those of its subsidiaries. In addition, we launched our television advertising campaigns in select markets beginning in January 2004, following a test in several markets during the fourth quarter of 2003.

Content Acquisition

We acquire content either through revenue sharing agreements or direct purchases. Under our revenue sharing agreements with studios and distributors, we generally obtain titles for a low initial cost in exchange for a commitment to share a percentage of our subscription revenues for a defined period of time. After the revenue sharing period expires for a title, the agreements generally grant us the right to acquire for a minimal fee a

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percentage of the units for retention or sale by us. The balance of the units are destroyed or returned to the originating studio. The principal terms of each agreement are similar in nature but are generally unique to each studio. In addition to revenue sharing agreements, we also purchase titles from various studios, distributors and other suppliers on a purchase order basis.

Fulfillment Operations

We currently stock more than 18,000 titles on more than 12 million DVDs. During December 2003, we shipped to and received from subscribers more than 18 million DVDs. We have allocated substantial resources to developing, maintaining and testing the proprietary technology that helps us manage the fulfillment of individual orders and the integration of our Web site, transaction processing systems, fulfillment operations, inventory levels and coordination of our shipping centers.

We ship and receive DVDs from numerous shipping centers located throughout the United States. We believe our shipping centers allow us to improve the subscription experience for subscribers by shortening the transit time for our DVDs through the U.S. Postal Service. Based on performance standards established by the U.S. Postal Service for its postal zones, we currently provide one-day delivery service to approximately 61 percent of the U.S. population, or 80 percent of our subscribers. We anticipate increasing such one-day coverage marginally as we open additional shipping centers to meet our growing demand.

Customer Service

We believe that our ability to establish and maintain long-term relationships with subscribers depends, in part, on the strength of our customer support and service operations. We encourage and utilize frequent communication with and feedback from our subscribers in order to continually improve our Web site and our service. Our customer service center is open seven days a week. We utilize e-mail to proactively correspond with subscribers. We also offer phone support for subscribers who prefer to talk directly with a customer service representative. We focus on eliminating the causes of customer support calls and automating certain self-service features on our Web site, such as the ability to report and correct most shipping problems. Our customer service center is located in our San Jose, California facility.

Competition

The market for in-home filmed entertainment is intensely competitive and subject to rapid change. Many consumers maintain simultaneous relationships with multiple in-home filmed entertainment providers and can easily shift spending from one provider to another. For example, consumers may subscribe to HBO, rent a DVD from Blockbuster, buy a DVD from Wal-Mart and subscribe to Netflix, or some combination thereof, all in the same month.

Video rental outlets and retailers with whom we compete include Blockbuster, Hollywood Entertainment, Amazon.com, Wal-Mart Stores and Best Buy. In particular, Blockbuster has launched in 25 percent of its U.S.-based operations a store-based subscription program in 2003 and plans to launch this program nationwide by the end of 2004. This program will provide many of the benefits of our business model in a store-based retail environment. We believe that we compete with these video rental outlets and movie retailers primarily on the basis of title selection, convenience and price. We believe that our scalable business model, our subscription service with home delivery and access to our comprehensive library of more than 18,000 titles compete favorably against traditional video rental outlets.

We also compete against other online DVD subscription services, such as Walmart.com and FilmCaddy.com, a subsidiary of Blockbuster, subscription entertainment services, such as HBO and Showtime,

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pay-per-view and VOD providers, and cable and satellite providers. Blockbuster has announced that it plans to roll out an online subscription service in late 2004 and then integrate the online and store-based subscription programs sometime in 2005. We believe we are able to provide greater subscriber satisfaction due to the broader and deeper selection of titles we offer subscribers, our ability to personalize our library to each subscriber based on the subscriber’s selection history, personal ratings and the tastes and preferences of similar users through our recommendation service and extensive database of user preferences, as well as the ease and speed with which subscribers are able to select, receive and return titles.

VOD has received considerable media attention recently. For example, VOD is now widely available in most major hotels and has early deployments in many major cable systems. Within a few years, we believe VOD will become widely available to digital cable and satellite subscribers. VOD carries as many titles as can be effectively merchandized on a set-top box platform, which we believe to be generally up to 100 recent releases plus adult content. In late 2003, Disney tested a proprietary broadcast VOD service, MovieBeam, which utilizes a set-top device connected to the television set to allow subscribers to download and view approximately 100 films at any time. For consumers who primarily want the latest big releases, VOD may be a convenient distribution channel. We believe that our strategy of developing a large and growing subscriber base and our ability to personalize our library to each subscriber by leveraging our extensive database of user preferences positions us favorably to provide digital distribution of filmed entertainment as that market develops.

Employees

As of December 31, 2003, we had 567 full-time employees. We also utilize part-time and temporary employees, primarily in our fulfillment operations, to respond to the fluctuating demand for DVD shipments. As of December 31, 2003, we had 224 temporary employees. Our employees are not covered by a collective bargaining agreement, and we consider our relations with our employees to be good.

Intellectual Property

We use a combination of patent, trademark, copyright and trade secret laws and confidentiality agreements to protect our proprietary intellectual property. In 2003, we were issued a broad business method patent covering, among other things, our subscription rental service. The patent will expire in 2020. In addition to the patent covering the rental method invention, we have filed additional patent applications. We have a registered trademark for the Netflix name and copyrights on the content of our Web site. We have filed applications for additional trademarks as well.

Enforcement of intellectual property rights is costly and time consuming. To date, we have relied primarily on proprietary processes and know-how to protect our intellectual property. It is uncertain if and when our other patent and trademark applications may be allowed and whether they will provide us with a competitive advantage.

From time to time, we encounter disputes over rights and obligations concerning intellectual property. We believe that our service offering does not infringe the intellectual property rights of any third party. However, we cannot assure you that we will prevail in any intellectual property dispute.

Other Information

We were incorporated in Delaware in August 1997 and completed our initial public offering in May 2002. Our principal executive offices are located at 970 University Avenue, Los Gatos, California 95032, and our telephone number is (408) 317-3700. We maintain a Web site at www.netflix.com. The contents of our Web site are not incorporated in, or otherwise to be regarded as part of, this annual report on Form 10-K. In this annual report on Form 10-K, “Netflix,” the “Company,” “we” and the “registrant” refer to Netflix, Inc.

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Our investor relations Web site is located at http://ir.netflix.com. We make available, free of charge, on our investor relations Web site under “SEC Filings” our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to these reports as soon as reasonably practicable after electronically filing or furnishing those reports to the Securities and Exchange Commission.

Item 2.     Properties

As of December 31, 2003, we occupied the following leased facilities:

In addition, as of December 31, 2003, we have entered into leases for a total of approximately 126,000 square feet to house our shipping centers serving major metropolitan areas throughout the United States. These leases expire at various dates through November 2006.

We believe our leases are suitable and adequate for our current needs, although we expect to negotiate additional leases in 2004 to accommodate our growth.

Item 3.     Legal Proceedings

From time to time, we are subject to legal proceedings that arise in the ordinary course of our business, including claims relating to employee relations and business practices. However, we believe that these proceedings are not likely to result in judgments that will have a material adverse effect on our business, financial condition or operating results.

Item 4.     Submission of Matters to a Vote of Securities Holders

None.

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PART II

Item 5.     Market for Registrant’s Common Equity and Related Stockholder Matters

Our common stock has traded on the NASDAQ National Market under the symbol “NFLX” since our initial public offering on May 29, 2002. The following table sets forth the high and low per-share closing prices of our common stock for the periods indicated, as reported by the NASDAQ National Market:

On January 16, 2004, our Board of Directors declared a two-for-one stock split in the form of a stock dividend on our outstanding common stock. The additional shares of common stock were distributed on February 11, 2004. All common share and per-share amounts have been retroactively restated throughout this annual report on Form 10-K to reflect this stock split.

As of February 12, 2004, there were approximately 95 stockholders of record of our common stock, although there is a significantly larger number of beneficial owners of our common stock.

We have not declared or paid any cash dividends, and we have no present intention of paying any cash dividends in the foreseeable future.

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Item 6.     Selected Financial Data

The following selected financial data is not necessarily indicative of results of future operations and should be read in conjunction with “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Item 8. Financial Statements and Supplementary Data.”

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Item 7.     Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion of our financial condition and results of operations should be read in conjunction with our financial statements and related notes under “Item 8. Financial Statements and Supplementary Data” of this annual report on Form 10-K.

Overview

Our Business

We are the largest online movie rental subscription service in the United States, providing more than 1,487,000 subscribers access to a comprehensive library of more than 18,000 movie, television and other filmed entertainment titles. Our standard subscription plan of $19.95 per month allows subscribers to have three titles out at the same time with no due dates, late fees or shipping charges. Subscribers can view as many titles as they want in a month. Subscribers select titles at our Web site (www.netflix.com) aided by our proprietary recommendation service, receive them on DVD by first-class mail and return them to us at their convenience using our prepaid mailers. Once a title has been returned, we mail the next available title in a subscriber’s queue.

Key Business Metrics

For the year ended December 31, 2003, we generated total revenues of $272.2 million and net income of $6.5 million. Management periodically reviews certain key business metrics in order to evaluate the effectiveness of our operational strategies, allocate resources and maximize the financial performance of our business. These key business metrics include the following:

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Please see “Results of Operations” below for further discussion on these key business metrics.

New Initiatives in 2004

Looking ahead, we will continue to focus on our online DVD rental subscription service in the United States. We will continue to make steady improvements in our service driving what we refer to as the “virtuous cycle”: Our continued service improvements create high subscriber satisfaction, which results in lower subscriber churn and positive word-of-mouth about our service. This in turn helps us grow our subscriber base faster. As we grow, we continue to make more improvements to our service, which drives the cycle again.

In addition to our core focus, we are planning on executing the following new initiatives in 2004:

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Descriptions of Statement of Operations Components

Subscription Revenues:

We generate all our revenues in the United States. We derive substantially all of our revenues from monthly subscription fees and recognize subscription revenues ratably during each subscriber’s monthly subscription period. We record refunds to subscribers as a reduction of revenues. In addition to our standard services of $19.95 per month, we offer other service plans with different price points that allow subscribers to keep either fewer or more titles at the same time. As of December 31, 2003, more than 92 percent of our paying subscribers paid $19.95 or more per month.

Cost of Subscription Revenues:

We acquire titles for our library through traditional direct purchase and revenue sharing agreements. Traditional buying methods normally result in higher upfront costs than titles obtained through revenue sharing agreements. Cost of subscription revenues consists of revenue sharing expenses, amortization of our library, amortization of intangible assets related to equity instruments issued to certain studios in 2000 and 2001 and postage and packaging costs related to shipping titles to paying subscribers. Costs related to free-trial subscribers are allocated to marketing expenses.

Revenue Sharing Expenses.    Our revenue sharing agreements generally commit us to pay an initial upfront fee for each DVD acquired. Revenue sharing expenses are recorded as DVDs subject to revenue sharing agreements are shipped to subscribers. Under certain of our revenue sharing agreements, we pay an additional minimum revenue sharing fee for each DVD shipped to a subscriber. Other than the initial upfront payment for DVDs acquired, we are not obligated to pay any minimum revenue sharing fee on DVDs that are not shipped to subscribers. We characterize these payments to the studios as revenue sharing expenses.

Amortization of DVD Library.    On January 1, 2001, we shortened the estimated life of DVD library to one year and assumed a salvage value of $2.00 for the DVDs that we believe we will eventually sell. Prior to January 1, 2001, we amortized our cost of DVDs using a “sum-of-the-month” accelerated method over an estimated life of three years and assumed no salvage value.

Amortization of Intangible Assets.    In 2000, in connection with signing revenue sharing agreements with Columbia TriStar Home Entertainment, Dreamworks International Distribution and Warner Home Video, we agreed to issue to each of these studios our Series F Non-Voting Preferred Stock equal to 1.204 percent of our fully diluted equity securities outstanding. In 2001, in connection with signing revenue sharing agreements with Twentieth Century Fox Home Entertainment and Universal Studios Home Video, we agreed to issue to each of the two studios our Series F Non-Voting Preferred Stock equal to 1.204 percent of our fully diluted equity securities outstanding. As of December 31, 2001, the aggregate of Series F Non-Voting Preferred Stock granted to these five studios equaled 6.02 percent of our fully diluted equity securities outstanding. Our obligation to maintain the studios’ equity interests at 6.02 percent of our fully diluted equity securities outstanding terminated immediately prior to our initial public offering in May 2002. The studios’ Series F Preferred Stock automatically converted into 3,192,830 shares of common stock upon the closing of our initial public offering. We measured the original issuances and any subsequent adjustments using the fair value of the securities at the issuance and any subsequent adjustment dates. The fair value was recorded as an intangible asset and is amortized to cost of subscription revenues ratably over the remaining term of the agreements which initial terms were either three or five years.

Postage and Packaging.    Postage and packaging expenses consist of the postage costs to mail titles to and from our paying subscribers and the packaging and label costs for the mailers. The rate for first-class postage was $0.34 prior to June 29, 2002 and increased to $0.37 thereafter.

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Operating Expenses:

Fulfillment.    Fulfillment expenses represent those expenses incurred in operating and staffing our shipping and customer service centers, including costs attributable to receiving, inspecting and warehousing our library. Fulfillment expenses also include credit card fees and other collection-related expenses.

Technology and Development.    Technology and development expenses consist of payroll and related expenses we incur related to testing, maintaining and modifying our Web site, our recommendation service, telecommunications systems and infrastructure and other internal-use software systems. Technology and development expenses also include depreciation of the computer hardware and capitalized software we use to run our Web site and store our data.

Marketing.    Marketing expenses consist of payroll and related expenses, marketing program expenditures and other promotional activities, including revenue sharing expenses, postage and packaging expenses and library amortization related to free trial periods.

General and Administrative.    General and administrative expenses consist of payroll and related expenses for executive, finance, content acquisition and administrative personnel, as well as recruiting, professional fees and other general corporate expenses.

Stock-Based Compensation.    During the second quarter of 2003, we adopted the fair value recognition provisions of Statement of Financial Accounting Standards (“SFAS”) No. 123, Accounting for Stock-Based Compensation, as amended by SFAS No. 148, Accounting for Stock-Based Compensation—Transition and Disclosure, an Amendment of FASB Statement No. 123, for stock-based employee compensation. We elected to apply the retroactive restatement method under SFAS No. 148 and all prior periods presented have been restated to reflect the compensation costs that would have been recognized had the fair value recognition provisions of SFAS No. 123 been applied to all awards granted.

During the third quarter of 2003, we began granting stock options to our employees on a monthly basis. The vesting periods provide for options to vest immediately, in comparison with the three to four-year vesting periods for stock options granted prior to the third quarter of 2003. As a result of immediate vesting, all stock-based compensation expense determined under SFAS No. 123 is fully recognized upon the stock option grants. For those stock options granted prior to the third quarter of 2003 with three to four-year vesting periods, we continue to amortize the deferred compensation related to those stock options over the remaining vesting periods.

Critical Accounting Policies and Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires estimates and assumptions that affect the reported amounts of assets and liabilities, revenues and expenses and related disclosures of contingent assets and liabilities in the financial statements and accompanying notes. The Securities and Exchange Commission has defined a company’s critical accounting policies as the ones that are most important to the portrayal of a company’s financial condition and results of operations, and which require a company to make its most difficult and subjective judgments. Based on this definition, we have identified the critical accounting policies and judgments addressed below. Although we believe that our estimates, assumptions and judgments are reasonable, they are based upon information presently available. Actual results may differ significantly from these estimates under different assumptions, judgments or conditions.

Amortization of DVD Library and Upfront Costs

In late 2000 and early 2001, we began entering into a series of revenue sharing agreements with studios, which substantially changed our business model for acquiring DVDs and satisfying subscriber demand for titles.

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These revenue sharing agreements enable us to acquire DVDs at a lower upfront cost than traditional direct purchase arrangements. We share a percentage of the net revenues generated by the use of each particular title with these studios over a fixed period of time, generally twelve months for each title. At the end of the revenue sharing period for each title, we typically have the option of either returning the DVDs associated with the title to the studio or purchasing some or all of those DVDs.

Before the change in our business model, we typically acquired fewer copies of a particular title and utilized each copy over a longer period of time. The implementation of these revenue sharing agreements improved our ability to acquire larger quantities of newly released titles and satisfy a substantial portion of subscriber demand for such titles over a shorter period of time. On January 1, 2001, we revised the amortization policy for the cost of our library from a “sum-of-the-month” accelerated method using a three-year life to the same accelerated method of amortization using a one-year life.

The change in life has been accounted for as a change in accounting estimate and was accounted for on a prospective basis from January 1, 2001. Had we continued to amortize the DVDs acquired prior to January 1, 2001 using a three-year life, amortization expense for 2001 would have been $4.7 million lower than the amount recorded in our financial statements.

Under our revenue sharing agreements, we remit an upfront payment to acquire titles from the studios. This payment includes a contractually specified initial fixed license fee that is capitalized. Certain of these payments also include a contractually specified prepayment of future revenue sharing obligations that is classified as prepaid revenue sharing expense and is expensed as revenue sharing obligations are incurred. The initial fixed license fee is amortized on a “sum-of-the-month” basis over one year.

We believe the use of the accelerated method is appropriate for the amortization of our DVD library and the initial fixed license fee because we normally experience heavy initial demand for a title, which subsides gradually once the initial demand has been satisfied.

Stock-Based Compensation

We account for stock-based compensation expenses in accordance with the fair value recognition provisions of SFAS No. 123. During 2001, 2002 and 2003, we recorded total stock-based compensation expenses of $6.3 million, $8.8 million and $10.7 million, respectively. The application of SFAS No. 123 requires significant judgment, including the determination of the expected life and volatility for stock options. To determine the expected life, we review the historical pattern of exercises of stock options. Prior to the third quarter of 2003, we granted stock options which generally vest over three to four-year periods. Since the third quarter of 2003, we began granting fully vested stock options to our employees on a monthly basis. As a result, we changed the expected life from 3.5 years to 1.5 years. In addition, our stock price has fluctuated significantly and has risen considerably in recent periods. These factors affect our assumptions used in determining the volatility. Given the volatile market conditions, it is difficult to forecast our stock-based compensation expenses, and changes in our assumptions could materially impact the amount of stock-based compensation expenses recorded in future periods.

Income Taxes

We record a tax provision, if any, for the anticipated tax consequences of the reported results of operations. In accordance with SFAS No. 109, Accounting for Income Taxes, the provision for income taxes is computed using the asset and liability method, under which deferred tax assets and liabilities are recognized for the expected future tax consequences of temporary differences between the financial reporting and tax bases of assets and liabilities, and for operating losses and tax credit carryforwards. Deferred tax assets and liabilities are measured using the currently enacted tax rates that apply to taxable income in effect for the years in which those tax assets are expected to be realized or settled. We record a valuation allowance to reduce deferred tax assets to the amount that is believed more likely than not to be realized.

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If we subsequently realize deferred tax assets that were previously determined to be unrealizable, the respective valuation allowance would be reversed, resulting in a positive adjustment to earnings in the period such determination is made. In addition, the calculation of tax liabilities involves significant judgment in estimating the impact of uncertainties in the application of complex tax laws. Resolution of these uncertainties in a manner inconsistent with management’s expectations could have a material impact on our results of operations and financial position.

Results of Operations

The following table sets forth, for the periods presented, the line items in our Statements of Operations as a percentage of total revenues. The information contained in the table below should be read in conjunction with the financial statements and notes thereto included in “Item 8. Financial Statements and Supplementary Data” of this annual report on Form 10-K.

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Revenues

The increase in our subscription revenues from 2002 to 2003, and from 2001 to 2002, was primarily attributable to an increase in the average number of paying subscribers. We believe the increase in the number of paying subscribers was driven by the continuing consumer adoption of DVD players, increased consumer awareness of our service and continuing improvements in our service.

Subscriber churn declined to 4.8 percent in the fourth quarter of 2003 from 6.3 percent in the same period of 2002. We believe the decline was primarily attributable to two reasons:

The following table presents our ending subscriber information:

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Cost of Revenues

The increase in cost of subscription revenues in absolute dollars from 2002 to 2003 was primarily attributable to the following factors:

The increase in cost of subscription revenues in absolute dollars from 2001 to 2002 was primarily attributable to the following factors:

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The increase in cost of subscription revenues from 2001 to 2002 was partially offset by a $4.2 million decrease, or 21 percent, in DVD amortization. The decrease was primarily attributable to a $4.7 million increase in amortization in 2001, which was caused by the change in the estimated life of our DVD library from three years to one year effective January 1, 2001, partially offset by an increase in amortization related to increased acquisitions for our DVD library.

Gross Margin

The decrease in gross margin from 2002 to 2003 was primarily due to a higher percentage of DVD amortization as a result of increased acquisitions for our library, coupled with a higher percentage of postage and packaging expenses as a result of an increase in disc usage per average paying subscriber. The decrease in gross margin was partially offset by a lower percentage of revenue sharing expenses as a result of our rental mix shifting proportionately in favor of purchased titles and away from titles subject to revenue sharing agreements.

Gross margin increased from 2001 to 2002 primarily as a result of the growth in our subscription revenues and a decrease in our direct incremental costs of providing those subscription services, coupled with the 21 percent reduction in DVD amortization.

Operating Expenses:

Fulfillment

The increase in fulfillment expenses in absolute dollars from 2002 to 2003 was primarily attributable to an increase in personnel-related costs resulting from the higher volume of activities in our customer service and shipping centers. In addition, our credit card fees increased $3.0 million from 2002 to 2003 as a result of the increase in subscriptions. The increase in fulfillment expenses in absolute dollars from 2001 to 2002 was also attributable to an increase in personnel-related costs, coupled with a $1.7 million increase in credit card fees. As a percentage of revenues, fulfillment expenses decreased from 2002 to 2003, and from 2001 to 2002, primarily due to a combination of an increasing revenue base and improvements in our fulfillment productivity due to our continuous efforts to refine and streamline our fulfillment operations.

As of December 31, 2003, we were operating a nationwide network of shipping centers. We anticipate opening additional shipping centers to continue to reduce delivery times and increase library utilization. We expect our fulfillment expenses will increase in absolute dollars in 2004 as a result of higher credit card fees and the continued increase in the volume of activities in our customer service and shipping centers.

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Technology and Development

The increase in technology and development expenses in absolute dollars from 2002 to 2003 was primarily the result of an increase in personnel-related costs, partially offset by a modest decrease in the depreciation of computer hardware and capitalized software. As a percentage of revenues, technology and development expenses decreased primarily due to a greater increase in revenues than technology and development expenses.

The decrease in technology and development expenses in absolute dollars from 2001 to 2002 was primarily caused by decreases in personnel-related costs as a result of employees terminated as part of our restructuring in 2001. As a percentage of revenues, technology and development expenses decreased primarily due to an increase in revenues and a decrease in the amount we spent on technology and development.

We continuously research and test a variety of potential improvements to our internal hardware and software systems in an effort to improve our productivity and enhance our subscribers’ experience. As a result, we expect our technology and development expenses will continue to increase in absolute dollars in 2004.

Marketing

The increase in marketing expenses in absolute dollars from 2002 to 2003 was primarily attributable to an increase in the number of new subscriber additions, which resulted in higher marketing program costs. In addition, personnel-related costs increased in order to support the higher volume of marketing activities. Subscriber acquisition cost increased from 2002 to 2003 primarily as a result of an increase in certain marketing program payments, partially offset by the continued growth of word-of-mouth as a source of subscriber acquisitions and lower personnel-related costs on a per-acquired subscriber basis. As a percentage of revenues, the decrease in marketing expenses was primarily due to a greater increase in revenues than marketing expenses.

The increase in marketing expenses in absolute dollars from 2001 to 2002 was primarily attributable to an increase in the number of new subscriber additions, which resulted in higher marketing program costs. In addition, personnel-related costs increased in order to support the higher volume of marketing activities. However, subscriber acquisition cost decreased from 2001 to 2002 primarily due to costs related to free trials and personnel-related costs increasing only moderately in absolute dollars but declining on a per-acquired subscriber basis due to the large increase in new trial subscribers. As a percentage of revenues, the decrease in marketing expenses was primarily due to a greater increase in revenues than marketing expenses.

We anticipate that our marketing expenses will increase in absolute dollars in the future periods as a result of an increase in the free-trial offers and other additional marketing programs. In particular, we plan to include

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television advertising into the mix of acquisition channels to grow our subscriber base. However, we believe that online and word-of-mouth advertising will continue to be the primary sources of generating the bulk of new subscribers in 2004.

General and Administrative

The increase in general and administrative expenses in absolute dollars from 2002 to 2003, and from 2001 to 2002, was primarily attributable to an increase in the number of personnel, as well as an increase in insurance costs and professional fees, to support our growing business. As a percentage of revenues, the decrease in general and administrative expenses was primarily due to a greater increase in revenues than general and administrative expenses.

We expect our general and administrative expenses will continue to increase in absolute dollars in 2004 in order to support our growing operations.

Stock-Based Compensation

We began granting fully vested stock options to our employees on a monthly basis beginning in the third quarter of 2003. Compensation expenses associated with these stock options are immediately recognized. For stock options granted prior to the third quarter of 2003 with three to four-year vesting periods, we continue to amortize the deferred compensation associated with these stock options over their remaining vesting periods using the accelerated method of amortization.

The increase in stock-based compensation expenses in absolute dollars from 2002 to 2003 was primarily due to higher compensation expenses as a result of the fully vested monthly stock option grants, coupled with a rising stock price. In addition, the increase was also attributable to higher compensation expenses associated with shares of common stock issued under our employee stock purchase plan.

The increase in stock-based compensation expenses in absolute dollars from 2001 to 2002 was primarily due to higher amortization of deferred compensation of stock options with three to four-year vesting periods, coupled with compensation expenses associated with shares of common stock issued under our employee stock purchase plan, which was adopted during 2002.

The calculation of our stock-based compensation expenses is highly sensitive to the market price of our common stock on the date of grant. Our stock price has been volatile and, as such, it is difficult to predict our stock-based compensation expenses in future periods.

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Interest and Other Income

The increase in interest and other income from 2002 to 2003 was primarily attributable to an increase in interest income as a result of higher average cash and investment balances.

The increase in interest and other income from 2001 to 2002, despite the decline in interest rates, was primarily attributable to an increase in interest income in the second half of 2002 as a result of higher average cash and investment balances. The increase in our cash and investment balances was primarily due to the proceeds from our initial public offering in May 2002.

Interest and Other Expense

Interest and other expense in 2002 included a one-time charge of $10.7 million associated with our early repayment, following our initial public offering in May 2002, of all outstanding indebtedness under our subordinated promissory notes related to the acceleration of the accretion of the unamortized discount.

Excluding the one-time charge of $10.7 million incurred in 2002, interest and other expense decreased from 2002 to 2003 primarily due to a reduction in interest-bearing obligations, some of which were repaid following our initial public offering in May 2002.

Interest expense increased from 2001 to 2002 primarily due to the one-time charge of $10.7 million incurred in 2002.

Liquidity and Capital Resources

Since inception, we have financed our activities primarily through a series of private placements of convertible preferred stock, subordinated promissory notes, our initial public offering and cash generated from operating activities. As of December 31, 2003, we had cash and cash equivalents of $89.9 million and short-term investments of $45.3 million. Although we currently anticipate that the proceeds from our initial public offering, together with our available funds and cash flow from operations, will be sufficient to meet our cash needs for the foreseeable future, we may require or choose to obtain additional financing. Our ability to obtain financing will depend, among other things, on our development efforts, business plans, operating performance and condition of the capital markets at the time we seek financing. We cannot assure you that additional financing will be available to us on favorable terms when required, or at all. If we raise additional funds through the issuance of equity, equity-linked or debt securities, those securities may have rights, preferences or privileges senior to the rights of our common stock, and our stockholders may experience dilution. Please refer to “Factors that May Affect Future Results of Operations” below for further discussion.

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The following table summarizes our cash flow activities:

Operating Activities

The increase in net cash provided by operating activities from 2002 to 2003 was primarily attributable to net income generated in 2003 as compared to a net loss incurred in 2002, adjusted for an increase in the amortization of our DVD library as a result of increased purchases of titles during 2003, an increase in accounts payable as a result of our growing operations, an increase in deferred revenue due to a larger subscriber base and an increase in stock-based compensation expenses. The increase in net cash provided by operating activities from 2002 to 2003 was partially offset by the decrease in non-cash interest expense in 2003. Non-cash interest expense included a one-time charge of $10.7 million related to an early debt repayment in 2002.

The increase in net cash provided by operating activities from 2001 to 2002 was primarily attributable to a smaller net loss incurred in 2002 as compared to 2001, adjusted for an increase in deferred revenue due to a larger subscriber base, an increase in interest expense due to a one-time charge of $10.7 million related to an early debt repayment, and an increase in accrued expenses and stock-based compensation expenses. The increase in net cash provided by operating activities from 2001 to 2002 was partially offset by the gain on disposal of DVDs and a lower amortization of DVD library incurred in 2002.